Why You Should Buy Gold If You Foresee Deflation, Not Inflation (CGL)

Last update on May 30, 2016.

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Conventional wisdom says that we should buy gold when we expect to see high inflation. The argument is simple: gold prices generally keep up with the rate of inflation, so when inflation is high, gold prices  should rise.

Five years ago, as gold prices approached $1,900 USD/oz (U.S. dollars an ounce), a stream of endless talking heads appeared on business TV channels and newspapers to promote the idea that gold was headed to $4,000 USD/oz or more.

Their reasoning was simple.

The Federal Reserve, which is the U.S. central bank with the authority to “print money”, had just initiated what is known as “Quantitative Easing (QE)”. Many of these talking heads saw QE as a form of printing money, and they thought that the policy would lead to very high inflation, much like what Germany experienced in the 1920s and what Venezuela is experiencing today.

Today, we know that these talking heads were very wrong about the effects of QE. Since 2011, inflation averaged roughly 2% per year in the U.S. and Canada, which is actually below the 100 year average of about 3% per year. Gold prices cratered from almost $1,900 in 2011 to about $1,200 today, so it’s safe to assume that the talking heads have lost their clients a lot of money.

However, I’m skeptical that gold would have been a good investment even if inflation had gone much higher. I became skeptical when I read about how George Soros saw gold as a bet on deflation, which is the opposite of inflation.

Known as the “man who broke the Bank of England”, Soros is one of the most successful speculators alive. He earned that nickname from having made $1 billion in a single bet against the British Pound, which the Bank of England tried to prop it up. Soros has made a lot of money from other bets that have gone against conventional wisdom, so when he speaks, I listen.

Soros bought gold in late 2009 in the aftermath of the financial crisis. Gold prices traded at around $1,100 USD/oz back then, so it’s reasonable to assume that he paid around that price. But instead of worrying about inflation like the other talking heads, he seemed to really be concerned about the prospect of deflation. He feared that the European governments were making huge mistakes with regards to their economic policy, and that such mistakes would cause another financial crisis which would lead to deflation.

Fortunately for the world, his biggest fears didn’t materialize. European leaders did just enough to prevent a full blown crisis, and so in early 2011, he sold out of gold as prices hovered around $1,500 USD/oz, citing his view that the risks of deflation had dissipated.

Frustratingly, however, he never explained why he thought gold was a good investment in times of deflation when the other talking heads thought the exact opposite. However, upon reflecting on this for a while, I believe I know the answer. Let me explain what I think Soros’ reason is.

When some “investment guru” thinks gold will be a good investment during highly inflationary periods, he or she is likely not taking interest rates into account. We must consider interest rates because they offer an alternative to gold. Let me clarify what I mean using an example.

Suppose we think inflation rates will be much higher in the future - say 10% per year. We therefore think gold prices will go up by 10% per year going forward, which is a higher rate of return than what stocks have given in the past. That means we should invest in gold, right?

Not necessarily.

Suppose that at the same time, interest rates on government bonds are at 11% per year. There is virtually no chance that the government will default on those bonds, so you’re pretty much guaranteed to make 11% per year by investing in the bond. Now ask yourself - what would you invest in? The bond or the gold?

If you’re like most people, you would choose the bond. As more people choose to invest in bonds over gold, the price of gold will stay stagnant or even go lower.

Now, here’s the thing: When inflation is high, central banks around the world generally try very hard to bring it back down. Usually, they try to achieve this by raising interest rates (long story) to levels above inflation. For example, in the 80s, 10 year maturity U.S. bonds yielded about 4% more than inflation.

But what if interest rates are lower than inflation? You would think then, that more people would choose to invest in gold rather than in bonds, but it’s not so simple. If a government bond yields 9% per year, investors have certainty that they will receive 9% per year, whereas with gold, there is only a theoretical promise that its price will go up at the rate of inflation. Therefore, I believe that many people would choose to buy bonds instead of gold when interest rates are relatively high, even when inflation is running higher.

On the other hand, I think people are much more likely to choose gold over bonds when both interest rates and inflation are very low. When bonds are yielding 1% per year as they’re doing now, I think people are more likely to give a shot at investing in riskier assets, and that includes gold.

Furthermore, gold has rightly or wrongly always been seen as a safe haven asset during times of trouble. I think humans have this fundamental urge to reach for cash whenever trouble hits, and gold is seen as a sort of universal currency.

Trouble and gold tend to accompany each other. This is particularly true during financial crises such as we saw in 2008. Contrary to many people’s beliefs, commercial banks, not the central banks of the world, create most of the money that we use every day (again, long story). When commercial banks lose so much money that they flirt with bankruptcy, the loss of confidence in the banking system leads to financial crisis, and it also causes deflation as commercial banks stop creating money.

Deflation is terrible for the economy. As prices of things go down over time, the same amount of money can buy more and more things as time passes - in other words, money becomes more valuable over time. This leads people to hoard money and not spend it, which may sound fine until you realize that one person’s spending is another person’s income. Less spending leads to more people being out of work, and it’s why unemployment was so high during the Great Depression.

Recognizing the dire effects of deflation, central banks will generally fight very hard to lift inflation higher when inflation falls below 2% per year. They usually do this by lowering interest rates, which is why the Federal Reserve engaged in QE to lower the 10 year interest rates on U.S. bonds to below 2% per year.

During times of deflation, gold prices therefore benefit from two forces - very low interest rates and a flight to safety. I believe this is the reason why gold has been one of the best performing assets throughout the last financial crisis, and why it’ll likely do well when the next financial crisis comes.

Therefore, whether you want to invest in gold or gold mining stocks should depend on whether you see another financial crisis soon. Some people, such as George Soros, are on the alert today. Soros in particular sees a lot of parallels between the conditions leading up to the U.S. financial crisis, and China today, and cited it as the reason for investing back into gold in recent months.

However, you should keep in mind that no one, not even Soros, always gets such prognostications right. As a case in point, Soros was wrong about an impending European crisis in 2010. There are also other highly respected investors, such as Ray Dalio, who believe that China will be weak, but not critical.

At any point in time, I can guarantee that someone somewhere will expect to see a financial crisis soon. Therefore, you should always make up your own mind about what you think will happen.

Now, suppose you think that a crisis will appear. What are some of the best ways of investing in gold?

One way is to invest in a gold commodity ETF. These ETFs track the price of gold, so if gold  goes up by 10%, you should get an almost 10% return (the difference being fees). The iShares Gold Bullion ETF (Ticker: CGL.TO) is such an ETF that trades in Canada.

Another way to invest in gold is to invest in gold mining stocks. However, I would caution most people against investing in individual gold stocks. Mining companies have a reputation for overpromising and under-delivering, and separating the wheat from the chaff is difficult.

A much better way, I believe, is to invest in an ETF that contains dozens of gold mining stocks. The iShares S&P/TSX Global Gold Index ETF (Ticker: XGD.TO) is such an ETF that trades in Canada. The drawback with such ETFs, however, is that their prices may not always track gold prices. If several gold stocks in the ETF go bankrupt, you could lose money on the ETF even as gold prices go up. But in general, gold mining ETFs should track the price of gold.

I hope that you now have a better understanding of when and how to invest in gold or gold related investments. If you decide to invest in gold, all the best to you. As for myself, I’m not inclined to get into gold yet, but that may change sometime in the months and years ahead.

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